If, as many investment experts are saying today, volatility is the new normal in equity markets, it makes even more sense than ever to structure a portfolio that can help isolate you to some extent from these major market swings.
The problem: Volatility plays a significant role in determining a portfolio’s compound return, which ultimately affects value.
The solution: Investors should work to design portfolios that over time, experiences less fluctuation in returns. And, while nothing is guaranteed (note 2008 returns), investors still have a much better chance of mitigating volatility by owning more broadly diversified portfolios. The key is to stay away from investments that typically are more volatile, i.e. individual stocks (e.g. in the latest downturn…AIG, Washington Mutual, British Pete, etc.), single country funds (e.g. Greece, etc.) and sector funds (e.g., health care funds, financial sector funds, energy sector funds, etc.).
Remember, lower volatility of returns produces a higher compound return and preserves more portfolio value. Note the chart below. Although portfolio #1 experiences a strong gain in year one, this gain is more than eliminated in year 2 (think dot-com stocks in 1999 and 2000). Portfolio #2, on the other hand, experiences a much smaller gain and loss during the two year period, and yet produces a higher compound return over the two years and preserves more portfolio value.
Impact on a Hypothetical $100,000 Portfolio
| Year 1 Return | Year 2 Return | Average Return | Compound Return | Value at End of Year 2 | |
| Portfolio #1 | 50% | -50% | 0% | -13.4% | $75,000 |
| Portfolio #2 | 10% | -10% | 0% | -0.5% | $99,000 |
The moral of the story: Investors who choose to hold individual stocks in their portfolios must be willing to accept greater risk than they would otherwise experience in a more diversified portfolio, and also, in the end, must be willing to accept the possibility of lower returns.
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Disclosure:
This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.
